Mad for Managed Futures

After their bang-up performance in 2008, everyone is talking about managed futures. They can make great diversifiers in some portfolios, but be sure to do your homework. They're opaque, often highly leveraged, and can be expensive.

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In May 1983, John Lintner, a Harvard Business School professor of finance, presented research that suggested that managed futures could act as a powerful diversifier for portfolios. Lintner found that when a portfolio of stocks was combined with “judicious investments in managed futures accounts,” the portfolio was significantly less risky than a portfolio of stocks only or a portfolio of stocks and bonds. Nearly three decades later, and after managed futures notched solid gains when the rest of the market was going bust, the once esoteric securities are going mainstream as money managers race to make them over in mutual fund and ETF wrappers for the retail set.

Proponents of the asset class say they are negatively correlated with equities and other asset classes, such as commodities and bonds (in other words, when equities, commodities and bonds go down, managed futures go up) and they certainly held up in 2008, when everything else was falling apart. The Barclay CTA Index, which tracks 565 managed futures programs, returned 14.09 percent in 2008, as every other asset class was under water. The S&P 500 Index was down 38.49 percent for the year, by comparison. Other asset classes, such as commodities, world stocks and real estate, also tanked, losing 23.74 percent, 42.08 percent and 43.12 percent, respectively, according to Attain Capital Management, a managed futures broker.

Managed futures' bang-up performance amid the meltdown chaos caught the market's attention and generated a lot of buzz among professional investors and financial advisors. Suddenly everyone wanted in on the hottest asset class in town. Since 2008, investment managers have launched at least 10 new mutual funds in the space, bringing the total to about 15; the first managed futures ETF, the Managed Futures Strategy Fund (WDTI), was rolled out in January by WisdomTree. Meanwhile, a number of broker/dealers have added managed futures mutual funds to their platforms for the first time, including Raymond James Financial Services, Ameriprise, Janney Montgomery Scott, RBC Wealth Management, Merrill Lynch and Commonwealth Financial. Other firms have been adding aggressively to their offerings of managed futures mutual funds. While Fidelity rolled out its first managed futures mutual fund in 2007, the firm ramped up its offering in 2009 and 2010, adding five new funds to its platform during that time. Not surprisingly, assets in the space are on the rise. CTA assets, which do not include managed futures mutual funds, climbed to $267.6 billion at the end of 2010 from $206.4 billion at the end of 2008, according to BarclayHedge. Separately, assets in managed futures mutual funds grew to at least $6.5 billion as of January 2011, up from around $1.78 billion in 2008, according to Morningstar, though the rating agency points out it only tracks some of the most prominent funds.

Should advisors be wary of the hype? Yes. As Lintner's research showed allocations to managed futures can reduce risk in certain portfolios. But it's got to be done right. Managed futures are opaque investments, returns are highly dependent on manager skill, they often use a lot of leverage, and fees are high. Meanwhile, low correlation to other asset classes, which proponents say is their primary benefit, isn't guaranteed. Some say options on the VIX are a better way to hedge a portfolio. Still others are concerned about how managed futures mutual funds will be regulated, as registration requirements are up in the air, something that could affect fees.

Neophytes

Jay Batcha, founder and senior managing director at family office firm Optimal Capital in Traverse City, Mich., knows managed futures. He started using them in a limited partnership structure in his clients' portfolios in the mid-1980s. His core client business is comprised of high-net-worth families with $3 million or more in investable assets. His investments in managed futures have done nicely for his clients.

In 2008, that stellar year for managed futures, Batcha's client portfolios were overweight the asset class, with a 20 percent allocation. But at the end of the year, Batcha studied the trailing returns relative to long-term averages and saw that returns were at prior peaks. “It was a great time to rebalance,” he says. He reduced allocations to the asset class to 8 percent.

Batcha recommends all investors include non-correlated assets, such as managed futures, in their portfolios. But a lot of advisors have been using managed futures the wrong way and for the wrong reasons, he says. “Advisors who use managed futures as a temporary position lose the main benefit of reducing portfolio risk due to their lack of correlation with other assets.”

Louis Stanasolovich, CEO and president of Legend Financial, a fee-only RIA with $360 million in assets under management, agrees that many advisors use managed futures in the wrong way. “Many advisors are neophytes when it comes to managed futures,” he says. That's because they're so new to the retail space, he says. Stanasolovich, who invests in managed futures via limited partnerships, started using the investment vehicles in 2006, but studied them for two years prior to that. Most advisors don't want to spend the time educating themselves, he says.

“There's definitely a part of the population of advisors that has a limited, or very baseline knowledge of [managed futures],” says Edward Walters, first vice president and director of products and research at Janney Montgomery Scott, which offers managed futures on its platform. Janney tries to educate its advisors on the strategy through testing, online training and speaking at conferences.

“All they know is that that they have the ability to generate returns when the equity market is tanking,” says Ryan Davies, principal of Alternative Investment Consultants, which provides managed futures allocation strategies.

Of course, there are no guarantees that past correlations will hold up in the future. But the majority of the time, managed futures managers will have low or negative correlations to the equities markets, says Davies. The Barclay CTA Index had a correlation of 0.01 with the S&P 500 from 1980 to the present. By comparison, U.S. bonds had a correlation of 0.11 to the Barclay CTA Index, while world bonds had a zero correlation to the index over the same time period.

A correlation of 0.01 simply means that 1 percent of the time, managed futures and the S&P 500 moved in the same direction. When the correlation is negative, say -0.26, this means the asset classes in question will move in opposite directions 26 percent of the time. (If the correlation is zero, the directional moves of the asset classes will have no clear overall relationship to each other.)

Trend Following

Managed futures strategies have been used by hedge fund and commodity trading advisors since the 1970s, according to AQR Capital Management. The biggest subset of managed futures strategies is trend following, which accounts for about 90 percent of CTA assets, Morningstar says. Trend following managers have the ability to go long or short a number of different asset classes, including stocks, currencies, interest rates and commodities. When these markets are going up, they ride the trend up; when they're going down, they ride the trend down. You might call this performance chasing.

“Investors in mutual funds certainly do chase performance, but that's also part of the reason that trend following works,” says Brian Hurst, one of the portfolio managers of AQR's Managed Futures Strategy Fund (AQMIX). “Performance chasing activity itself can cause trends to continue and often push prices beyond fundamental fair values.”

The more a market moves, the higher the probability it will continue to move, says Davies. In other words, trends persist. “The more they drop, the more momentum they have.”

That said, all trends must come to an end. These strategies can underperform when the markets are choppy or trendless or when the markets experience a sharp reversion in trends, says Yao Hua Ooi, portfolio manager of the AQR fund.

A Piece of the Puzzle

While the returns of managed futures can be quite compelling, especially those from 2008, they won't fit in every portfolio.

Sean McGillivray, vice president at Great Pacific Trading Company, a commodities brokerage, says managed futures are not for everyone, and should never be used as a core investment. It's suitable for investors with income-producing years ahead of them and those who have a defined portion of their portfolio allocated to alternatives. They are not suitable for individual investors nearing or in retirement, or investors with low risk tolerance.

James Shelton, CIO of Houston-based wealth management firm Kanaly Trust, currently allocates 5 percent to managed futures in many accounts because he feels managed futures' negative correlation to so many asset classes is very valuable. In 2008, the firm allocated as much as 10 percent of client portfolios, but then scaled back in early 2009 because they felt the equity markets were picking up. Shelton's average client has $4 million in assets, and he typically uses a fund of CTAs to get exposure to different managers' strategies. Kanaly, which has $2 billion in assets, offers comprehensive financial planning and trust and estate planning to clients.

Shelton says Kanaly is considering investing in a mutual fund of managed futures, but he has unanswered questions about how these funds will be regulated, and what this will mean for how they are structured and the fees they charge. Today, managed futures mutual fund managers don't have to register as commodity pool operators with the Commodity Futures Trading Commission, as other CTAs do, but that might change. Shelton believes the mutual fund structure is a great way to get exposure to managed futures with daily liquidity and lower minimums, but under current rules, futures in mutual funds must be traded through an offshore entity, according to Morningstar. This structure has increased expenses associated with it, Shelton says, and he's not comfortable with those costs.

Meanwhile, RIA Warren Financial Service would rather use options on the VIX to hedge clients' portfolios because it's reverse-correlated to traditional asset classes, says Randy Warren, president and CIO. Warren, who trades the options himself, says options on the VIX are cheaper than investing in the futures market because you don't have the monthly rollover costs. Warren spent 10 years building options trading platforms for such banks as UBS and Credit Suisse in the 1990s, so he knows his derivatives.

When using a hedge, you want the volatility to be in the hedge, not in the long portfolio, and the more volatility in the hedge, the less you need to allocate to the hedge. With options on the VIX, you don't need to allocate as much because the volatility is higher, says Warren.

“I'm not really sure they [managed futures] are going to blow up in popularity as people think they are,” Warren says. “If you don't understand something and you dip your toe in, you can get burned.”

Don't Get Burned

Depending on the manager, managed futures strategies can also use a lot of leverage, says Michael Armitage, director of fund services at Standard & Poor's in Australia. For example, while Winton Capital, a London-based CTA, uses between three to six times leverage, some CTAs trade at 10 to 15 times leverage, he adds. Advisors need to take a close look at the underlying managers and the leverage they employ, he says.

Mutual fund investors can get exposure to managed futures through a passive, index-based fund; a fund of funds that invests in underlying CTAs; or an active manager that does its own trading. Other ways to get exposure to managed futures include hedge funds and managed account hedge fund platforms.

But the names of CTAs are not widely known by clients or advisors, says Randal Langdon, president of Lindner Capital Advisors, a separate account manager. That's why it might be a good idea to go with a fund of funds, a separate account manager or mutual fund, as they have already vetted these managers.

“Manager skill is highly important to long-term performance,” says Davies. You can try to replicate performance, but it simply won't be as consistent as that of highly-skilled managers.

Davies says the best way to evaluate a CTA manager is by looking at how the CTA performed during periods when CTAs in general did not do well. Those managers who lost the least money in bad times are most likely more skilled. Also, you don't want managers that gained the least during good periods.

Fees

Due diligence of managers is also crucial because the different products can be very expense-heavy, Langdon says. Most CTAs charge the typical “two and 20” hedge fund fee, which is 2 percent of assets and 20 percent of any profits earned. According to BarclayHedge, average management fees are 1.5 percent, while average incentive fees are 18 percent. Then the mutual fund managers charge a fee on top of that. These fees vary. For example, Rydex charges a 1.99 percent net expense ratio, while Altegris charges 2 percent. Meanwhile, AQR managed to get its expense ratio down to 1.25 percent because the firm is doing the trading itself, and doesn't have to pay underlying managers.

But Davies says fees are relative to performance (See table, page 45). The idea is, if the markets break apart, that part of your portfolio should be making money, so it would make sense to pay a premium for it, especially with the amount of leverage used.

“It's almost like a bit of insurance in the portfolio,” says Armitage.

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